Macroprudential policy is meant to reduce the risks from the financial sector spilling over to the wider economy. But the debate over how to do so goes on. This column argues that macroprudential policy can be analysed through the prism of market failures that it is supposed to address.

The purpose of macroprudential policy is to reduce ‘systemic risk’. While hard to define formally, systemic risk is understood as 'the risk of developments that threaten the stability of the financial system as a whole and consequently the broader economy” (Bernanke, 2009). The notion is meant to include the types of financial imbalances that led to the 2007-2008 bust.

It is common to distinguish two key aspects of systemic risk. One is the “time-series dimension”: the procyclicality of the financial system, that manifests in excess risk-taking in booms and excess deleveraging in busts. Another is the ‘cross-sectional dimension’: the risk of contagion due to simultaneous weakness or failure of financial institutions. Accordingly, macroprudential policy it thought of as a set of tools that help reduce these two forms of risk (Borio 2009; Bank of England 2011).

Yet thinking about macroprudential policy by looking solely at these two dimensions of risk is unsatisfactory. First, this view, per se, does not provide a justification for regulatory intervention. For example, is it really desirable to avoid any form of cyclicality and have a zero risk of contagion in the financial system? Second, it is not a priori clear what can macroprudential policy achieve that traditional micro-prudential regulation cannot.

Understanding market failures

In a recent IMF study (DeNicolò et al. 2012), we aim to tackle these questions. We start by articulating that, as for any form of regulatory intervention, the objective of macroprudential regulation must be to address market failures.

Important market failures that create systemic risk are the risk externalities across financial institutions and between the financial sector and the real economy. The literature allows classifying such externalities as driven by 1) strategic complementarities (herding): the strategic interactions of financial institutions causing the build-up of vulnerabilities during the expansionary phase of a financial cycle; 2) fire sales: the generalised sell-off of financial assets causing a decline in asset prices and a deterioration of the balance sheets of intermediaries; and 3) interconnectedness: the risk of contagion caused by the propagation of shocks from systemic institutions or through financial networks. The need to correct these market failures offers a clear economic rationale to macroprudential policy.

The idea that macroprudential policy is needed to correct market failures, rather than to smooth financial cycles, is important, because prudential measures that restrict credit availability (and possibly bank profits) may encounter non-trivial political challenges. The identification and correction of market failures is a clearer, uncontroversial objective for a macroprudential regulator.

The emphasis on market failures that arise because of interaction between financial institutions also helps clarify why micro-prudential regulation is not enough for containing systemic risk. Micro-prudential regulation focuses on the individual stability of financial institutions. Having strong individual institutions is necessary but not sufficient to minimise systemic risk. For example, micro-prudential policy may not take sufficient account of correlation risks. Or, a focus on maintaining high capital ratios of individual institutions during a recession may result in asset fire-sales, exacerbating existing vulnerabilities. Hence the need for additional, macroprudential policy to try to correct such market failures.

An analysis of how these tools can correct the three identified externalities, summarised in Table 1 below, offers some important implications for the design of macroprudential policy.

Table 1. Externalities and macroprudential policies

One important result of the analysis is that each of the externalities can be corrected by multiple policy tools.

For example, both capital requirements and limits on bank asset allocation can correct the externalities associated with strategic complementarities of banks. Capital requirements induce banks to internalise more of the cost of engaging in risky lending; restrictions on asset allocation prevent banks from taking large risk exposures.

However, since capital requirements may become less effective in booms (when capital ratios increase due to buoyant asset prices), direct quantity restrictions, such as debt-to-income (DTI) or loan-to-value (LTV) ratios, can also be useful complements. These restrictions affect directly the asset side of banks’ balance sheet and are meant to limit the fall in lending standards during boom times.

Similarly, capital and stable funding measures are complements in addressing the risk of fire sales, since they focus on vulnerabilities stemming from different sides of a financial institution’s balance sheet. The externalities associated with fire sales arise because banks fail to internalise the consequences of not taking precautionary measures in normal times, and thus need to adjust by shedding assets ex-post in the event of a negative aggregate shock. Capital and liquidity requirements provide buffers that reduce the risk of fire sales.

Also, capital surcharges can weaken the incentives of banks to become systemic and ensure that they dispose of a larger buffer in case of distress. Complementary restrictions on the composition of bank assets (as envisioned e.g., by the Volcker rule) serve to limit banks’ exposure to excessive risk.

The second result, a corollary, is that since the alternative policy tools are often complementary, there is not a “silver bullet” policy instrument. Since each tool has different advantages and limitations, a combination is likely to provide a better solution to the problem of correcting the same externality. Goodhart et al. (2012) reach similar conclusions using a theoretical model of financial instability.

The third result is that capital surcharges, more than any other tools, can be effective in dealing with any of the externalities. For this reason, and because they are closely linked to microprudential regulation and are part of the Basel III framework, capital requirements (surcharges) are likely to form the core of any macroprudential policy framework. The other instruments can be seen as complements in cases when capital surcharges are less effective.

There are also important areas for further research. Even though the mapping from externalities to policy tools helps identify the pros and cons of alternative policy interventions, a major challenge in the implementation of macroprudential policy rests on the calibration of instruments. Despite recent evidence on the effectiveness of some tools, little is known quantitatively (Dell Ariccia et al. 2012). For example, it is far from clear how high capital surcharges should be, or what the optimal LTV ratio should be. Accordingly, further fundamental and applied research on the optimal choice and calibration of macroprudential policy tools is required to justify policy intervention and avoid regulatory discretion.

The views expressed in this column are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.